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- Investment opportunities using payback period and average rate of return (ARR)
- Investment opportunities using net present value (NPV) - HL only
The capital budget covers expenditure, the benefit of which is expected to arise over a number of income periods. The generation of investment proposals comes under capital budgeting.
Investment decisions involve committing funds to:
● Internal investment projects
● External investment projects
● Disinvestment of projects
The principal types of projects involving investment decisions are as follows:
1. New products: proposals for new products would involve market research, product research and development, production of prototypes as well as investment in new machinery and additional working capital.
2. New markets: new markets could involve a great deal of market research and testing and while it may not involve any new plant or machinery, the R&D of the new market would be viewed as a capital investment.
3. Replacement of fixed assets: this is the most common form of capital budget proposal. The evaluation of replacement decisions will involve assessment of the incremental costs and revenues arising from the decision to replace.
4. Takeovers and mergers
5. Disinvestments: these can involve the closure or the sale of an unwanted part of a business or of the sale of individual assets no longer required such as obsolete plant, equipment, land and buildings.
6. Others: investment proposals of varying size and importance can arise in any part of the business and for a multitude of reasons e.g. environmental, health, structural changes, management and systems development etc.
Capital Investment Process
Capital investment decisions normally represent the most important decisions that an organisation makes, since they normally commit a substantial proportion of a firm’s resources to actions that are likely to be irreversible. Many different capital investment projects exist including: replacement of assets, cost-reduction schemes, new product/service developments, product/service expansions, statutory, environmental and welfare proposals etc.
To appraise a potential capital project:
● Estimate the costs and benefits from the investment
● Select an appraisal method
● Use the appraisal method to ascertain if the investment is financially worthwhile
● Decide to go ahead with the project
It is important to note that the costs and benefits from the investment are estimates. Many take place in the future and many assumptions are made in calculating these figures. The costs and benefits for the investment are called cash flows. Only relevant costs should be used.
The main relevant cost rules are:
● Sunk costs (already incurred) should be ignored
● Only incremental costs should be included (those which will change as a result as a result of the decision)
● Non cash flows are excluded (including depreciation, provisions or allocated fixed costs – fixed costs which would be incurred whether or not the project goes ahead should be excluded)
● Opportunity costs should be included (developing one area of a business to the detriment of another).
Methods of Investment Appraisal
1: The Payback Period
Payback is ‘The time required for the cash inflows from the capital investment project to equal the cash outflows’. This method attempts to forecast how long it will take for the expected net cash inflows to pay back the net investment outlays (what money was initially put into the venture).
When deciding between two or more competing projects, the usual decision is to accept the one with the shortest payback. Payback should be a first screening process, and if a project gets through the payback test, it ought then to be evaluated with a more sophisticated project appraisal technique.
When payback is calculated, we take profits before depreciation because profit before depreciation is likely to be a rough approximation of cash flows.
Illustration 1
KLJ are considering purchasing a new machine. The machine will cost $550000. The management accountant of KLJ has estimated the following additional cash flows will be received over the next 6 years if the new machine is purchased:
Year 1: $40000
Year 2: $65000
Year 3: $140000
Year 4: $175000
Year 5: $140000
Year 6: $70000
KLJ has a target payback of 4 years. Calculate the payback period for the new machine and advise KLJ whether or not to proceed with the investment.
Payback is achieved sometime between years 4 & 5
The cumulative cash flow becomes positive in year 5, so payback is 4 years plus (130000/160000 x 12) months = 4 years 10 months.
KLJ have a target payback period of 4 years. The payback is after this target, so the advice to KLJ would be to not undertake the investment.
The most desirable project, under the Payback method, is the one which pays back the cash outlay in the shortest time.
Task 1: An investment of $15 million is expected to generate net cash flows of $3.5 million each year for the next 6 years. Calculate the payback for the period
Task 2: A haulage company has three potential projects planned. Each will require investment in two refrigerated vehicles at a total cost of $120,000. Each year has a three-year lifespan. The three projects are:
● Lease the vehicles to a meat-processing factory which will take the risks of finding loads to transport and will bear all driver costs for a three-year period. Expected cash inflows, after deducting all expected cash outflows are $60,000 per annum.
● Enter into a fixed price contract for three years to carry frozen foods from processing plants in the UK to markets in Continental Europe, returning with empty vehicles. This will require employing drivers on permanent contracts. Expected cash inflows after deducting all expected cash inflows are $45,000 per annum.
● Employ a contracts manager to find loads for outward and return journeys but avoid any contract for longer than a six-month period so as to have the freedom to take up opportunities as they arise. Drivers will be hired on short-term contracts of three months. Expected cash inflows, after deducting all expected cash outflows are $40,000 in Year 1 ; $70,000 in Year 2 and $80,000 in Year 3.
(a) Use the above information to calculate the payback period.
Task 3: Abbly Machines (AM) is considering making an investment of $1.2m on launching a new product. They have undertaken some market research and have estimated that the new product could generate the following cash flows:
AM requires payback within 4 years. Advise if they should go ahead with the investment
Task 4: Snocold Ltd (SL) is considering two projects. Both cost $450000 and only one may be undertaken. SL uses the payback method for appraising investments and requires payback within three years. The details of the cash flows for the two projects are given:
Advise SL which project they should undertake.
Advantages of Payback
● Long payback means capital is tied up
● Focus on early payback can enhance liquidity
● Investment risk is increased if payback is longer
● Shorter-term forecasts are likely to be more reliable
● The calculation is quick and simple
● Payback is an easily understood concept
Disadvantages of Payback
● It ignores the timing of cash flows within the payback period, the cash flows after the end of the payback period and therefore the total project return
● It ignores the time value of money. This means that it does not take account of the fact that $1 today is worth more than $1 in one year’s time.
● The method is unable to distinguish between projects with the same payback period
● The choice of any cut-off payback period by an organization is arbitrary
● It may lead to excessive investment in short-term projects
● It takes account of the risk of the timing of cash flows but does not take account of the variability of those cash flows.
Example of why payback alone is an inadequate project appraisal method
Project P paybacks back in 3 years and 3 months while Project Q paybacks in 2 years 6 months. Using payback alone to judge projects, project Q would be preferred. But the returns to Project P over its life are much higher than the returns from Project Q. Project P will earn total profits before depreciation of $200000 on an investment of $60000, whereas Project Q will earn total profits before depreciation of only $85000 on an investment of $60000.
Payback Period
Payback Period
2: AVERAGE RATE OF RETURN (ARR)
The average rate of return, like the payback period method, looks at the expected net cash flows (income - expenses) of the investment project. It then measures the average net return each year as a percentage of the initial cost of the investment. Let's look at an example. A firm is looking at buying a new automatic painting machine. The cost of the machine is 200,000 and the expected net cash flows are:
The total return from the project over the five years is 320,000 (the sum of the five years). If we subtract the original cost of 200,000 from this, we get the net return from the investment to be 120,000. This took 5 years to earn and so the annual return is 120,000 divided by 5 which is 24,000 per annum. To get the average rate of return, we use the following formula:
Average rate of return = Net return per annum x 100
Capital cost
From the figures above this gives us:
Average rate of return = 24,000 x 100 = 12%
200,000
This suggests that every £1 worth of investment yields an average 12p return each year.
Take the following information:
Task 5: Calculate the ARR for Projects 2 & 3
Advantages
● It is quick and simple to calculate
● It involves a familiar concept of a percentage return
● Accounting profits can be easily calculated from financial statements
● It looks at the entire project life
● Managers and investors are accustomed to thinking in terms of profit, and so an appraisal method which employs profit may therefore be more easily understood.
The drawbacks to the ARR method of project appraisal
● The ARR method does not take account of the timing of the profits from the project. Whenever capital is invested in a project, money is tied up until the project begins to earn profits which pay back the investment. Money tied up in a project cannot be invested anywhere else until the profits come in.
● It is based on accounting profits which are subject to a number of different accounting treatments
● It is a relative measure rather than an absolute measure and hence takes no account of the size of the investment
● It takes no account of the length of the project
● Like the payback method, it ignores the time value of money
Average rate of return (ARR)
Calculating ARR
3: Net Present Value
Discounted Cash Flow
The DCF method has gained widespread acceptance for it recognizes that the value of money is subject to a time preference, that is, that $1 today is preferred to $1 in the future unless the delay in receiving $1 in the future is compensated by an interest factor (receiving interest back on the loan).
The DCF method attempts to evaluate an investment proposal by comparing the net cash flows accruing over the life of the investment at their present value with the value of funds about to be invested
EXAMPLE
Given that the rate of interest is 10%, $1 invested now will be equal to $1.10 at the end of the year. Conversely, the value of $1.10 in a year’s time is worth $1 today if the rate of interest is 10%.
The value of $1 at the end of the year at 10% is $1 + 0.10 = $1.1
The value of $1 at the end of 2 years at 10% is ($1.1)² = $1.21
The value of $1 at the end of 3 years at 10% is ($1.1)³ = $1.331
The value of $1 at the end of 4 years at 10% = 1.4641
The value of $1 at the end of 5 years at 10% = 1.61051
You can also use the Discount Tables for this section
The present value of $1 receivable at a future date is as follows:
$1 receivable in one year is $1/(1.1) =$0.9091
$1 receivable in 2 years is $1/(1.21) = $0.8264
$1 receivable in 3 years is $1/(1.331) = $0.7513
$1 receivable in 4 years is 0.6830
$1 receivable in 5 years is 0.6209
The value of money is, therefore, directly affected by time, and the rate of interest is the method is used to express the time value of money. Compound interest tables and discount tables are available which show the value of money at different interest rates over a number of years.
Determining the discount factor
It is usual for the project manager to have discount rates set as part of the organisational policy. There are three factors which determine the discount rate:
a. The rate charged for the use of the capital
b. The rate due to inflation (so that the purchasing power is not reduced)
c. A premium factor due to the fact that the investor is taking a risk that the capital amount may never be repaid.
Overall rate = (1 + a)(1+b)(1+c)
Task 6: Discounted cash flows
● $5000 is invested in an account earning 2.75% interest p.a. Calculate the fund value after 12 years.
● $5000 is invested for 10 years in an account earning 5% interest p.a. Calculate how much this will be worth at the end of the 10 years.
● Find the present value of $2000 receivable in 6 years’ time, if the interest rate is 10% p.a.
● How much would $40000 receivable in 4 years time be worth in today’s value, if the interest rate is 7%?
● HJK Ltd can either receive $12000 in 2 years time or $14000 in 4 years time. The interest rate is 6%. Advise HJK which they should select.
● Find the present value of $15500 receivable in 5 years’ time, if the interest rate is 7% p.a.
NET PRESENT VALUE
The NPV method compares the present value of all the cash inflows from a project with the present value of all the cash outflows from a project. The NPV is calculated as the PV of cash inflows minus the PV of cash outflows.
● If the NPV is positive, it means that the present value of the cash inflows from a project is greater than the present value of the cash outflows. The project should be undertaken.
● If the NPV is negative, it means that the present value of cash outflows is greater than the present value of inflows. The project should not be undertaken.
● If the NPV is exactly zero, the present value of cash inflows and cash outflows are equal and the project will be only just worth undertaking.
Example
Corween Ltd is considering a project which has a life of five years and which will produce an annual inflow of $1000. The investment outlay is $3000 and the required rate of return is 10%.
The Net Present Value (NPV) method
Example: NPV
Slogger has a cost of capital of 15% and is considering a capital investment project where the estimated cash flows are as follows:
The PV of cash inflows exceeds the PV of cash outflows by $56160 which means that the project will earn a DCF yield in excess of 15%. It should therefore be undertaken.
Advantages of NPV
● Considers the time value of money – discounting cash flows back to present value takes account of the impact of interest.
● Is an absolute measure of return – the NPV of an investment represents the actual surplus raised by the project. This allows a business to plan more effectively
● Is based on cash flows not profits – the subjectivity of profits makes them less reliable than cash flows and therefore less appropriate for decision-making
● Considers the whole life of the project – methods such as payback only considers the earlier cash flows associated with the project. NPV takes account of all relevant flows. Discounting the flows takes account of the fact that later flows are less reliable.
● Should lead to the maximisation of shareholder wealth. If the cost of capital reflects the shareholders’ required return then the NPV reflects the theoretical increase in their wealth. For a commercial company, this is considered to be the primary objective of business.
Disadvantages of NPV
- It is difficult to explain to managers. To understand the meaning of the NPV calculation requires an understanding of discounting. The method is not as intuitive as methods such as payback
- It requires knowledge of the cost of capital. The calculation of the cost of capital is, in practice, a complex calculation
- It is relatively complex – for the reasons explained above NPV may be rejected in favour of simpler techniques.
- A disadvantage of the NPV calculation is that it requires you to make projections. You must estimate the dollar amount of the project's cost as well as its future income. In most cases, the NPV calculation will not be 100 percent accurate. A project may incur unforeseen costs that decrease its profitability. Income projections are difficult to determine with exact precision. In addition, a project may incur a negative cash flow instead of the projected positive one.
- The present value of a project is expressed in a dollar amount. Some business managers would rather see a percentage or rate of return. Although the NPV calculation discounts future cash flows using a required rate of return, it does not reveal the project's actual return. The calculation only reveals whether the project will return the required rate. A project may have a positive net present value, but the return may turn out to be less than desired. Higher dollar amounts do not necessarily translate into higher returns.
Task 7: Project B needs an investment of £30000 at a discounting rate of 12%. Is this a viable venture?
Task 8: The management of C Co plc is considering investing $25000 in a project with a potential life of six years. The company’s cost of capital is 18% per year. The net cash flows are projected as follows:
Task 9: A project requires an initial investment of $2.4 million. The following cash flows have been estimated for the life of the project:
Using a discount factor of 10%, calculate the NPV of the project.
Task 10: Slogger has a cost of capital of 15% and is considering a capital investment project, where the estimated cash flows are as follows:
Calculate the NPV of the project, and assess whether it should be undertaken.
Net Present Value
NPV explained
Task 11: Norwell Industries Ltd is studying two projects, each of which requires a net investment outlay of $3000. Both have a useful life of five years, and the estimated profile of the net cash inflows is:
The desired minimum rate of return is 10%
(a) Calculate the Net Present value for both Project A and Project B using the discount factor of 10%
(b) Which project should the firm choose, according to NPV
Task 12: MKP Ltd is considering two mutually exclusive projects with the following details:
Project A
Initial investment $45000
Scrap value in year 5 $2000
Project B
Initial investment $10000
Scrap value in year 5 $1000
Assume that the initial investment is made at the start of the project and the annual cash flows are at the end of each year. The scrap values should be treated as cash inflows in year 5.
Calculate the NPV for Projects A and B if the cost of capital is 10%
Task 13: A project requires an initial investment of $500000. The following cash flows have been estimated for the life of the project:
The company uses NPV to appraise projects. Using a discount factor of 7%, calculate the NPV of the project and recommend whether the project should be undertaken.
Combined investment appraisal methods
Task 14: Smiley Sweets is contemplating introducing a new machine into the production process. This will cost $59000. The budgeted after-tax profits and total cash income flow were as follows:
It will cost the firm $14000 to scrap the machine at the end of year 4
Assume that financial standards set for accepting investment proposals by the business are that they must:
a) Give an average rate of return of at least 16%
b) Give payback in 3 years
c) Have a positive NPV (cost of capital is 15%)
Task 15: A company is considering which of two mutually exclusive projects it should undertake. The company anticipates a cost of capital of 10% and the net after tax cash flows of the projects are as follows:
(a) Calculate the payback period of each project
(b) Calculate the Average Rate of Return (ARR) of each project
(c) Calculate the NPV of each project
(d) Determine the best project to pursue
Task 16: David Jones, the marketing director at Branigans, is keen to see the company diversify into neckties and he has to set up a small team to look at possible alternatives. They have identified two options. Project 1 involves marketing ties in Europe and will cost $300,000, while Project 2 costing $200,000 involves concentrating on the UK market. David Jones has produced budgeted figures for the two projects.
(a) The Payback Period
(b) The average rate of return (ARR)
(c) Calculate the Net Present Value of each project assuming a discount factor of 14%
Task 17: Zerfy sees an opportunity for a new product, gryavia, which is likely to have a five-year commercial life. The capital expenditure required for equipment is $750,000 and it is expected to have no scrap value at the end of the five years. The estimated cost of capital is 20%.
The estimated profits/losses for the five years are as follows:
Calculate
(a) The Payback period
(b) The average rate of return
(c) The net present value
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